Friday, September 26, 2008

A (Mild) Defence of TARP

(Luigi Spaventa at Vox) The Paulson-Bernanke Troubled Assets Relief Program (TARP), whereby the US Treasury would be endowed with $ 700 billion for the purchase of “troubled” financial instruments (and in particular mortgage-backed securities) to be sold at a later dater or held to maturity, has elicited widespread (and at time indignant) negative reactions from the best and brightest of the economists’ profession (though with notable exceptions, like Willem Buiter [i] and Charles Wyplosz [ii]). In the critics’ view the scheme, though inspired or shared by a trio of eminent former officials [iii], is ill-conceived and will likely end up by transferring taxpayers’ money to undeserving financial institutions: if urgent public intervention is required, there are fairer and more effective remedies.

Two preliminary remarks on the timing of the TARP initiative (or, for that matter, of any other proposal as bold and sizeable as TARP). First, its effectiveness is impaired by coming too late, as a hastily defined measure of last resort after the crisis has become acute. An earlier pre-emptive move (a solution similar to TARP was proposed in the Financial Times in April and in Vox and in CEPR Policy Insights in May) may have prevented the acceleration of the vicious feedback between the falling value of the assets of financial institutions and their capital and funding requirements. Second, however, once the Treasury and the Fed have jointly announced their emergency program, with the stark motivation that it is the only way to avoid an imminent meltdown, doing nothing or unduly delaying its implementation would increase uncertainty and plunge the markets into chaos.

There are two related aspects to the crisis besetting financial institutions which are now shrinking their balance sheets by cutting credit to the economy: (1) the illiquidity and falling value of some of their assets, and (2) a shortage of capital, as only 70% of the recognised losses have so far been matched by new capital. TARP attempts to address the first aspect, while its critics argue that public intervention should solely aim at the second.

The most relevant objection to TARP concerns the price at which the Treasury would buy the troubled assets, most of which have no market and are otherwise difficult to price because of their opaqueness and complexity. The unavoidable discretion in price setting can, according to critics, only lead to two outcomes: a mark-to-market price, which however would provide no relief as it would merely crystallise existing losses or even unveil new ones; or a higher price (the most likely outcome) which, while providing relief, would transfer the losses from the sellers to the taxpayer, helping moreover those financial institutions that made the worst investment decisions. The proposed alternatives are all variations on the theme of shoring up the banks’ capital: either by the government acquiring banks’ preferred stock (Krugman [iv]), possibly through a well-designed but rather complex scheme of matching the preferred stock assistance with a common stock issue (Calomiris [v]); or by forcing the financial companies to raise capital making rights offerings (Rajan [vi]), or by mandating debt-equity swaps (Zingales, Wolf [vii]).

In general, the view that, for at least some of the troubled securities, there does not exist a price which would relieve the position of financial firms without imposing a cost to the taxpayers is not robust. Available data and even pessimistic projections on default rates show that “market” prices reflect a negative bubble rather than “fair” values: a thorough analysis led the Bank of England to conclude “that using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately incur” [viii]. For a large class of securities, therefore, the alternative is not as stark as the critics maintain. As Chairman Bernanke believes, there does exist an intermediate price, high enough to provide relief, but low enough as not to inflict budgetary losses. The real problem lies in how that price can be discovered. The method of a reverse auction does not by itself prevent sellers’ opportunistic behaviour based on asymmetric information. As detailed in an important statement of the Director of the Congressional Budget Office [ix] , the conditions to avoid this outcome are that the auction should be for shares in the same asset rather that in different assets (hence not different complex products but homogeneous tranches) and that those shares be widely distributed among many potential sellers. If the auction is well-designed, on the other hand, the prices it establishes may provide the floor necessary to revive the markets, thereby re-creating liquidity. (What puzzles me about TARP is why cash is offered to purchase the troubled assets instead of guaranteed liquid bonds.)

The many alternatives based on public cum private capital injections are themselves not without problems. First and foremost, they leave the assets’ liquidity problem unsolved: if the fall of prices continues, injections of capital may prove inadequate after a short time (as has already happened). Second there are elements of discretion, and hence arbitrariness, in the alternative schemes as well. While a mandatory solution for all would be too invasive, targeting and deciding eligibility would imply a discretionary choice.

Ideally, both aspects of the problem – assets’ illiquidity and shortage of capital – should be addressed in sequence [x]. Taking the troubled assets off the banks’ books first would stabilise the losses incurred by the banks because prices would find a floor (or in the case of undeserving asset have openly sunk to the bottom). By removing uncertainty, this would at the same time encourage private injections of capital in some cases and provide more accurate information on the need for public intervention otherwise. Religious wars do not help in the search for pragmatic and constructive solutions.

[i] “A TAD (toxic Asset Dump) for USSA”,, September 20, 2008 and the comments to Calomiris and Rajan ,
[ii]Why Paulson is (maybe) right", Vox, 22 Septemer, 2008
[iii] Nicholas F. Brady, Eugene A. Ludwig, Paul Volcker “Resurrect the Resolution Trust Corp.”, The Wall Street Journal, September 17, 2008.
[iv] “Cash for Trash”, The New York Times, September 21, 2008
[vi] “Desperate times need the right measures”,, 19 September, 2008.
[vii]Why Paulson is wrong”, Vox 21 September, 2008; “Paulson’s plan was not a true solution to the crisis”, Financial Times, 23 September, 2008.
[viii] Financial Stability Report April 2008, p. 20. This is especially true for the triple-A securities, for which losses estimated at market prices are almost 80% higher than those based on model-implied prices. See also the letter to the Financial Times, 25 September, 2008, by Dan McLaughlin of Bank of Ireland Global Markets.
ix “Federal Responses to Market Turmoil”, Statement of Peter. R. Orszag, Septemer 24, 2008, which provides a balanced and insightful assessment of the alternatives. For another review of benefits and costs, see Douglas M. Elmendorf, “Concerns about the Treasury Rescue Plan”, Brookings, September 25, 2008.
x As suggested by Lucien A. Bebchuk, “A plan for addressing the financial crisis”, Harvard, Johnson M. Olin Center for Law, Economics and Business, Discussion Paper No. 628, September 2008, the Financial Times editorial of September 19, 2008, Sinon Johnson and James Kak, “The price of salvation”,, Economists’ forum, September 25, 2008.

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